Eastern Europe

In late 1989 the countries of Eastern Europe broke loose from the Soviet Union, threw off communism, and began to construct democratic institutions and market-oriented economies. This great transformation is founded on the idea that freedom and prosperity can best be advanced by adopting the institutions and practices that have proven successful in Western Europe since World War II. The people of the region want "to return to Europe." To do so, they plan to dismantle the remnants of the communist economic system and build market-oriented economies based on private ownership. While this is a daunting task, the transformation is well under way.

The Communist Inheritance

What complicates the process of economic transformation is the burden posed by the inheritance of the communist economic system. One Russian pundit, commenting on the communist legacy, explained that anyone can turn an aquarium into fish stew, but it is much harder to turn fish stew into an aquarium. The communist inheritance has had two important dimensions for Eastern Europe.

First, the laws, institutions, and ownership structure under communism are very different from what is needed for a modern, capitalist economy, so nearly all must be changed. Most important, the socialist ownership structure placed industry, services, and (with the exception of Poland) agriculture mainly in state hands. State ownership and central planning produced poor decisions about how to use resources and led to greatly distorted economies. Every Eastern European government skewed investment toward heavy industry and capital goods at the expense of light industry, services, and consumer goods.

Moreover, attempts to subsidize certain economic activities left all the countries with heavily distorted pricing structures. Prices for energy and household necessities (mainly food and rent) were kept very low. Another factor that distorted prices was the overvalued domestic currency. It was kept so overvalued that it could not be converted into foreign currency. Instead, governments rationed the limited amount of foreign exchange available. Those not receiving official exchange usually had to pay much more to buy dollars in the black market. Therefore, most imported goods were severely rationed or available only at high blackmarket prices.

Second, after forty years the communist economic system failed to sustain itself, leaving utter industrial collapse, financial distress and chaos, and very low living standards.

Some countries in Eastern Europe sought to stave off collapse by replacing central planning with decentralized decision making. These communist-led reforms brought some improvement but did not lead to the emergence of normal competitive market relations. In the end each country in the region suffered an economic collapse and a cessation of sustained growth, and in some cases, acute shortages, balance of payments crises, and financial chaos.

The genesis of the financial crises came from deep within the system. Subsidies ballooned as governments tried to keep the prices of many consumer products and services low for households and tried to keep profits high in state enterprises (where managers were too willing to grant excessive wage increases). Credits to enterprises also ballooned in support of the huge appetite for investments on the part of state enterprises (where managers craved investment projects that might add to their power and prestige). Subsidies and credits were paid by printing money, which led to a steady buildup of demand throughout these economies. The ballooning of demand created shortages wherever price controls were inflexible, inflation wherever prices were allowed to rise, and external debt and balance of payments crises in most countries. The buildup of demand in Poland, for example, can be seen clearly in the gap between the black market exchange rate and the official one, which rose from 250 percent in early 1988 to 500 percent in mid-1989.

The collapse of living standards was broadly felt across Eastern Europe. Industrial production did not slow appreciably because strenuous efforts were made to channel the available resources to heavy industry. The result of this strategy was a decline in living standards for the population. While there were substantial differences among countries in the region, the people of Eastern Europe found goods increasingly unavailable at official prices, longer queues and bigger shortages, an absence of imported consumer goods, and in some cases, a deterioration in public services and basic utilities such as heat and hot water.

The Strategies for Economic Transformation

As the new governments of Eastern Europe surveyed the ruins of the communist system and prepared to transform their economies, they were initially preoccupied with the question of whether to free prices from centralized control quickly in order to cope with the shortages, high inflation, and scarcity of dollars. Alternatively, they could first reform the laws, institutions, and ownership structure to allow private property. Freeing prices from centralized control in the absence of private property seemed risky to many, because state enterprises would be granted too much market power and would operate in an unruly and unregulated environment. But was it possible to privatize enterprises, eliminate monopolies, restructure the banking system, reform the tax system, and build a social safety net in the absence of realistic prices and in the midst of a financial crisis?

Most governments concluded that reform was a seamless web, such that liberalization and structural reforms must be woven together simultaneously. The pattern of the web, however, has varied from country to country. In some the financial collapse was so acute that there was no room for maneuver. The Solidarity government in Poland, for example, inherited a hyperinflation so debilitating that immediate steps were necessary. But Czechoslovakia, where the financial situation was not as acute and the communist-led reform was limited, spent one year attempting to prepare the way for marketization.

Despite some differences in approach, on the whole prices have been freed from centralized control quickly. Meanwhile, the longer, and in many respects harder, job of rewriting laws, building capitalist institutions, modernizing and restructuring industry, and privatizing capital and land is under way but will take years, if not decades, to complete. Most countries are finding that the introduction of market relations greatly facilitates this harder job, by providing a more stable, more responsive market environment in which structural adjustment can be done more effectively. After all, how could industry be modernized, privatized, and restructured without market signals to guide the process?

The countries of Eastern Europe have three basic elements of economic transformation in common: stabilization, liberalization, and privatization.

Stabilization efforts in Eastern Europe have aimed at creating a stable financial environment that will foster the rapid growth of domestic business activity, international trade, and foreign direct investment. By reducing budget deficits, slowing the growth of the money supply, and establishing realistic exchange rates, Czechoslovakia, Hungary, and Poland have ended the chronic shortages that have plagued their economies and have achieved low rates of inflation and relatively stable exchange rates.

Economic liberalization includes permitting households and enterprises to conduct business freely, buying and selling at prices set by supply and demand. This has meant, among other things, a sweeping elimination of government price controls. In most countries liberalization has also been backed by changes in the legal framework aimed at allowing private gain, and deregulation to limit government interference in economic activities. The new governments also understand that the success of liberalization requires the protection of private property and the freedom to start private businesses. These freedoms are needed to foster a new private sector that strengthens competitive forces and channels resources into productive capital investments.

Because the countries of Eastern Europe are small and situated near the great market of the European Economic Community, another important component of liberalization has been the opening up of international trade. In the short run the opportunity to trade with the West has provided instant competition, greatly diminishing the domestic monopoly power of monolithic state enterprises. In the long run, international trade holds the key to the eventual integration of the economies of Eastern Europe with the economies of the West.

While the combination of liberalization and stabilization has helped restore the health of public finances and create a stable financial environment, these radical changes have also thrust the people of Eastern Europe into unfamiliar circumstances. Consumers accustomed to long lines and empty stores now face an abundance of goods, but at much higher prices. A journalistic account from Poland's 1990 liberalization records the reaction of a prominent editor: "I cry when I pay for gas, but one of the worst miseries of my existence—the endless hunting and queuing for fuel—is over. When I first filled up hassle-free in January, I was euphoric." (See Ziomecki.)

The elimination of price controls caused large initial jumps in consumer prices in Albania, Bulgaria, Czechoslovakia, and Poland. Because wages increased by a smaller percent, the measured real wage in each country has declined. This apparent decline in real wages, however, is misleading because few consumer goods had been available at the controlled prices. When prices rose after being freed from controls, shortages were eliminated and more goods were available. As one Polish journalist wrote, "Up to now, we have not been buying television sets because they were not available, whereas now, we are not buying them because they are too expensive." (See Skalski.)

The Eastern European economies are responding strongly to the opening up of international trade. Most countries in the region have increased exports, which will increase economic integration with the West. In Poland, for example, exports to the West rose from $8.5 billion in 1989 to about $13 billion in 1991, a period in which Poland's GDP was falling. Poland's ability to market its goods abroad has moderated the decline in living standards. The growth in Eastern European exports is vital to the modernization of the region because it provides the finance for needed imports of capital and technologies.

Liberalization of economic activity has also sparked the growth of private sector activity. The emergence of a new private sector has perhaps been greatest in Poland, where hundreds of thousands of new small businesses were opened in 1990, but Hungary and Czechoslovakia are not far behind. In Warsaw roughly 90 percent of retail shops are now in private hands. The service sector, long suppressed under the communist system, is mushrooming, and new private manufacturing activity is beginning, though still on a modest scale.

At the same time, the state enterprise sectors are declining in all Eastern European countries. Industrial production has fallen by 15 to 40 percent in these countries, and in some countries the decline may not be over. In part, these sectors must give way because their activities had been planned to suit the "communist production circle" mentioned earlier. In part, the decline has resulted from the collapse of the Soviet Union, which abruptly stopped trading with Eastern Europe at the beginning of 1991.

Continued state ownership has retarded the adjustment and restructuring needed to adapt the activities of state enterprises to markets. State enterprise managers no longer report to central planners or branch ministries, and are now all too free to manage state property for their own gain. Where labor unions have power, enterprise managers may also prefer to use enterprise profits to boost wages and buy calm in the workplace, rather than to undertake restructuring investments. This only worsens the international competitiveness of the sector. In addition, managers of state enterprise often appropriate state property. Some managers intentionally bankrupt government firms in order to buy them out cheaply. Others establish private firms that then receive preferential contracts with the state-owned enterprises. Still others accept unfavorable joint-venture and takeover offers that provide personal benefits.

Privatization is widely regarded by the new governments of Eastern Europe as a necessary step to making the best economic use of state property. It is well understood that much of the capital stock inherited from the past is dilapidated, based on outmoded technologies, and aimed at the now-collapsed Soviet market. The decisions of what to shut down, what to restructure, and what to modernize are best made by private owners with a true stake in the economic future of the firm.

The privatization challenge is enormous. The countries of Eastern Europe must privatize a wide range of property, including trucks, housing, shops, foreign trading firms, commercial banks, small manufacturing operations, and huge industrial concerns. Most countries have quickly privatized physical property and small shops. Auctions, leases, and other techniques have put a large proportion of retail trade and small service establishments in private hands in several countries. Because large industrial enterprises are more difficult to privatize, they are being privatized slowly.

Several countries initially flirted with the notion of adopting Western privatization techniques—such as public offerings of enterprise stock—for selling large industrial enterprises. These techniques have been too slow and too expensive. Margaret Thatcher's government privatized about two dozen firms in a decade; the countries of Eastern Europe have thousands of industrial enterprises to privatize. Efforts to prepare public offerings in Eastern Europe have come up against the facts that

1. selling enterprises requires valuation (which is impossible given the uncertainties surrounding these enterprises and these economies);

2. domestic investors in Eastern Europe do not have the financial resources to buy up their own industrial sectors; and

3. the purchase of too many large enterprises by foreigners is politically undesirable.

As a result, Eastern European countries have developed and implemented novel approaches. In Czechoslovakia citizens have purchased privatization vouchers that can be used to bid for enterprise shares. This approach is intended to allow all citizens the chance to gain from the privatization process. In Hungary enterprises are encouraged to prepare privatization plans, seek out investor groups, and make privatization proposals to the State Property Agency. In Poland some shares will be given directly to workers and managers. In addition, shares in large industrial enterprises will be distributed to newly created investment funds, which, as part owners, will exercise active control over enterprise managers by taking a role on boards of directors. Shares in the investment funds will be distributed to the population via some form of a voucher scheme. This approach is intended both to allow all Poles to gain from privatization and to generate a mechanism for investor scrutiny of enterprise management.

About the Author

David Lipton is an economist with the Moore Capital Strategy Group in Washington, D.C. He previously was undersecretary of the treasury for international affairs.

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